Don’t Overlook the Insolvency Exemption for 1099-C Cancelation of Debt Income

It’s that time of year again, when people are receiving 1099-Cs for debts forgiven or canceled during 2013. Perhaps you were in a debt settlement program with successful results, and a lot of debt was forgiven. Or it may be that your creditor decided to formally cancel an old delinquent account to close out their records. You might have taken the DIY approach and negotiated your own discounted payoffs for credit card debt, or even an underwater second mortgage. Any of these outcomes will result in the receipt of 1099-Cs.

It feels unfair to many, but a 1099-C is treated by the IRS as ordinary income. There’s nothing you can do about receiving the 1099-Cs, since the creditors are required to report canceled debt exceeding $600. But you can educate yourself about the legitimate options for relief on the tax bill associated with cancelation of debt income (CODI). IRS Publication 4681 provides detailed information on the two main exemptions: the Mortgage Forgiveness Debt Relief Act, and the exemption for insolvency.

The Mortgage Forgiveness Debt Relief Act expired as of December 31st, 2013, and it remains to be seen whether Congress will extend it again. This exemption was limited to mortgage debt associated with the purchase of the principal residences, or refinanced mortgages up to the original loan balances. If you had qualified mortgage debt forgiven in 2013, you can still take advantage of this exemption for the 2013 tax year.

The insolvency exemption applies to just about any type of debt cancelation, and permits taxpayers to exclude CODI from taxable income to the extent their liabilities exceeded the “fair market value” of their assets just before the cancelation. In other words, this is a net worth calculation. If your debts are greater than your assets, your net worth is negative and you are insolvent to that extent. Income from any 1099-Cs can be offset up to the amount by which you were insolvent.

Even though this exemption has existed in the IRS code for many years, millions of dollars in legitimate tax exemptions are left on the table every year, simply because taxpayers (and even many paid tax preparers) do not understand the insolvency exemption, or do not think it applies to them.

One common mistake is believing you cannot claim this exemption if you are working and have a regular income. This is not the case at all. Since the calculation for insolvency is a comparison of assets to liabilities, income does not enter into it. You can have income and still be insolvent.

Others mistakenly think that insolvency is the same thing as bankruptcy. You do not need to have filed bankruptcy to declare the insolvency exemption, and if you had filed there would be no need to utilize this exemption anyway, since any associated tax liability can normally be discharged as part of the bankruptcy itself.

Further, many people give up and skip claiming the exemption when they see the very complicated official instructions for IRS Form 982. It can take many hours of frustrated reading and re-reading to digest what these instructions are actually saying, and there are still many common scenarios not discussed therein.

If you’re thinking that tax software will solve the problem of Form 982, be aware that existing tax software programs are very limited when it comes to handling CODI, the main problem being lack of support for calculating insolvency across a series of multiple 1099-Cs. Since the insolvency calculation is supposed to take place just before the debt cancelation, your figures for assets and liabilities will shift as each successive debt is retired.

Then, of course, there is the dreaded Part II of Form 982, where the taxpayer is supposed to “reduce basis in tax attributes.” This is an entirely separate calculation, with instructions that leave most people scratching their heads with frustrated bewilderment. Most people just leave Part II completely blank, a mistake that could potentially trigger an audit of your insolvency calculations.

Part of the problem is that Form 982 includes a number of scenarios that would never apply to most taxpayers, so the instructions are far more complicated than necessary. A Form 982-EZ would be a very good idea!

For consumers dealing with 1099-Cs and feeling confused, professional tax assistance is highly recommended. Just make sure your tax preparer is thoroughly familiar with this area!

If you’re doing your own taxes, you can save hours of time and frustration by using the Insolvency Calculator from ZipDebt.com. This Excel-based spreadsheet calculator includes support for multiple 1099-Cs, and comes with a user guide and examples showing different common situations. Available for instant download, this inexpensive product can potentially save you hours of time in figuring out the correct figures to show on Form 982.

My experience is that yes proof of insolvency is a method of avoiding the 1099 c tax liability but it is not easy to prove if you are being audited and you bear the burden of proof. Bankruptcy is the other option which does not directly involve insolvency. Yes filing the bankruptcy shows your lack of assets at the time of filing normally but bankruptcy eliminates the 1099 because you don’t owe the debt. A Debtor may be solvent and have more assets than liabilities but still avoids the 1099-c tax problem because there is a specific provision of the code for persons that file which eliminate it. Also after you file bankruptcy any later charge off for debt that was listed at the time of filing the bankruptcy is eliminated because there was no obligation for the debt.

http://www.zipdebt.com/ Charles Phelan

Nick, no argument from me on what you’re saying here about discharge of the tax liability via bankruptcy. But obviously, lots of people have already settled accounts or had old collection accounts canceled and will be receiving 1099-Cs accordingly. So the main point of the article was that anyone receiving a 1099-C should not overlook the insolvency exemption. I wish I had a dollar for every time a consumer told me they didn’t think they could claim it because they had an income, etc.

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